Why life firms will never deliver building society-style bonanzas

Insurance de-mutualisation is not quite what it seems.

As the bids for Scottish Amicable mount into the stratosphere, policyholders should be wary of the numbers touted by prospective bidders. Valuations of insurance companies are full of traps for the unwary and the figures rarely mean what they seem to at first sight.

Members of mutual insurers are unlikely ever to see such large windfalls as the ones being handed out to their building society counterparts, who will receive up to pounds 20bn worth of shares this year as a result of conversions from mutual status to ordinary banks.

The headline number of Abbey National's offer for ScotAm is pounds 1.4bn. But policyholders have already discovered that they will not receive anything like as much. Their true cash windfall is no more than pounds 400m.

The explanation for the discrepancy between the value of these mutuals and the amount policyholders will be paid for giving up ownership lies in the complex regulations and actuarial and accounting procedures that govern them.

Indeed, some of the money in these offers is not new cash at all but may ultimately come from the policyholders themselves - in effect bringing forward payments of bonuses they would have received in the future.

Here we attempt to answer some of the questions that have arisen about the value of mutual insurers over the last few weeks.

Why are building societies worth so much more to their members than mutual insurers?

The basic reason is the difference in the way the two types of society have operated. Early building societies shared their profits with their members. But for many years, the majority have behaved just like conventional banks, setting market rates for mortgages and deposits, and making substantial annual profits.

With no dividends to pay to shareholders, building societies have built up enormous free reserves. These belong to the members and the value is distributed in cash or shares when a society converts.

Insurers have kept much closer to the ideals of mutuality. They have behaved very like the early building societies by distributing profits to members as they go along. They offer annual and terminal bonuses, which are basically a regular payment of profits.

What does this do to the value of a mutual insurer?

Rather than build up large reserves, most have retained little more than the working capital they require to back the growth of the business. There is usually very little to distribute as a windfall on conversion.

Is this a safe way to run a mutual?

Normally yes, but sometimes they grow so fast that they do not have enough reserves as working capital to back their expansion. These strains sometimes push mutuals into selling out, and analysts say this lies behind the decision by ScotAm to demutualise.

Why was ScotAm offering only pounds 75m to its policyholders to persuade them to relinquish mutual ownership?

You cannot get something for nothing. Since ScotAm's reserves are needed for working capital in the business, there is no surplus to give away to policyholders, as there would be with a building society. So the payment essentially comes from policyholders' own funds, as an advance payment on the proceeds of the flotation ScotAm wants in three to five years' time.

How does the flotation change things?

ScotAm claims it will run the business better - and make it more valuable - with the help of a pounds 350m cash injection to the with-profits fund from Swiss Re.

Only strongly capitalised life funds find it prudent to have a large proportion of equity investments, which generally bring higher returns. With the money, and further help from Swiss Re's partner Securitas, ScotAm hoped to achieve these higher returns and sell more policies. Present policyholders would only gain if the management of the new business did improve profitability dramatically. ScotAm held out the prospect of a pounds 200-pounds 400m further payment on flotation.

But didn't ScotAm say that it aimed to make the company worth pounds 1bn at flotation? If so, where would the rest of the money have gone?

Stock market shareholders in ScotAm Plc - as the company would have become after flotation - would be buying an interest in the new business and in the life funds, as well as repaying Swiss Re's pounds 350m.

However, policyholders do not just have equity and bond investments through their policies. They also own the embedded value in the life fund, which is the current worth of the entire future stream of income it is expected to generate as it grows.

Shareholders in a demutualised life insurer are entitled to take 10 per cent of the future profits, which hitherto had belonged entirely to policyholders. This of course has to be paid for.

Most of the money shareholders would subscribe on flotation would be to compensate policyholders for the loss of part of their future profits from the fund. It fills the hole left by the lost stream of future profits, so there is no surplus to distribute to policyholders.

So why was Abbey National saying it wanted to pay pounds 1.4bn upfront?

In exactly this way, Abbey National is promising to pay around pounds 1bn for the embedded value of the life fund.

However, as an outsider, it can afford to pay an additional pounds 400m premium for goodwill. ScotAm could not do this because it only had policyholders' own funds to play with. Abbey's was a good offer, until Prudential came along.

What is so special about the Pru's offer?

The Pru, headed by Peter Davies, has tried a different tack. It has a large life fund of its own, which can easily absorb the whole of the ScotAm fund.

But if that happens, ScotAm no longer needs to finance a large sales force and all the other paraphernalia required to attract new business. It no longer has any need, therefore, for working capital. By closing down ScotAm to new business in this way, the Pru is able to release pounds 400m for its existing policyholders. The rest of the pounds 1.9bn the Pru is offering comprises a pounds 1.1bn repayable loan and pounds 400m in goodwill.

The most interesting feature of the Pru offer is therefore that it is giving back to ScotAm policyholders their own money, released from the embedded value of their own life fund, which it proposes to close. All future new business will be written from the Pru's own fund.

So where does that leave ScotAm?

At present, there are three offers. Two of them - ScotAm's own and the Pru's - in different degrees pay policyholders a slice of their own money, through the use of clever financial engineering. Abbey National offers cash payment, but then so does the Pru, in addition to its bonus plan. This makes its offer the best.

The bidding war has probably not finished. But remember that the board does not have to sell to the highest bidder, and can take the needs of employees and future policyholders into account in its decision.

Voices
The Sumatran tiger, endemic to the Indonesian island of Sumatra, is an endangered species
voicesJonathon Porritt: The wild tiger population is thought to have dropped by 97 per cent since 1900
News
Gardai wait for the naked man, who had gone for a skinny dip in Belfast Lough
newsTwo skinny dippers threatened with inclusion on sex offenders’ register as naturists criminalised
Sport
Van Gaal said that his challenge in taking over Bobby Robson's Barcelona team in 1993 has been easier than the task of resurrecting the current United side
football
News
news
PROMOTED VIDEO
Arts and Entertainment
Beast would strip to his underpants and take to the stage with a slogan scrawled on his bare chest whilst fans shouted “you fat bastard” at him
musicIndie music promoter was was a feature at Carter gigs
Arts and Entertainment
Story line: Susanoo slays the Yamata no Orochi serpent in the Japanese version of a myth dating back 40,000 years
arts + entsApplying the theory of evolution to the world's many mythologies
News
Performers dressed as Tunnocks chocolate teacakes, a renowned Scottish confectionary, perform during the opening ceremony of the 2014 Commonwealth Games at Celtic Park in Glasgow on July 23, 2014.
news
Life and Style
Popular plonk: Lambrusco is selling strong
Food + drinkNaff Seventies corner-shop staple is this year's Aperol Spritz
Life and Style
Shake down: Michelle and Barack Obama bump knuckles before an election night rally in Minnesota in 2008, the 'Washington Post' called it 'the fist bump heard round the world'
newsThe pound, a.k.a. the dap, greatly improves hygiene
Arts and Entertainment
La Roux
music
Arts and Entertainment
Graham Fellows as John Shuttleworth
comedySean O'Grady joins Graham Fellows down his local Spar
News
people
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
Ross Burden pictured in 2002
people
News
Elisabeth Murdoch: The 44-year-old said she felt a responsibility to 'stand up and be counted’'
media... says Rupert Murdoch
Arts and Entertainment
tv
Extras
indybest
Sport
Arsenal signing Calum Chambers
sportGunners complete £16m transfer of Southampton youngster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Entry Level Fund Accountant (Edinburgh)

£17 - £20 per hour: Cameron Kennedy Recruitment: My client, one of the worlds ...

SQL DBA/Developer

£600 per day: Harrington Starr: SQL DBA/Developer
 SQL, C#, VBA, SQL Server, ...

Risk Analyst - VBA/EXCEL

£300 - £600 per day: Harrington Starr: Risk Analyst Access, EXCEL, VBA, RISK, ...

Market Access Analyst (FIX 5.0, Equities, Derivatives)

Negotiable: Harrington Starr: Market Access Analyst (FIX On-boarding, FIX 5.0,...

Day In a Page

The children were playing in the street with toy guns. The air strikes were tragically real

The air strikes were tragically real

The children were playing in the street with toy guns
Boozy, ignorant, intolerant, but very polite – The British, as others see us

Britain as others see us

Boozy, ignorant, intolerant, but very polite
Countries that don’t survey their tigers risk losing them altogether

Countries that don’t survey their tigers risk losing them

Jonathon Porritt sounds the alarm
How did our legends really begin?

How did our legends really begin?

Applying the theory of evolution to the world's many mythologies
Watch out: Lambrusco is back on the menu

Lambrusco is back on the menu

Naff Seventies corner-shop staple is this year's Aperol Spritz
A new Russian revolution: Cracks start to appear in Putin’s Kremlin power bloc

A new Russian revolution

Cracks start to appear in Putin’s Kremlin power bloc
Eugene de Kock: Apartheid’s sadistic killer that his country cannot forgive

Apartheid’s sadistic killer that his country cannot forgive

The debate rages in South Africa over whether Eugene de Kock should ever be released from jail
Standing my ground: If sitting is bad for your health, what happens when you stay on your feet for a whole month?

Standing my ground

If sitting is bad for your health, what happens when you stay on your feet for a whole month?
Commonwealth Games 2014: Dai Greene prays for chance to rebuild after injury agony

Greene prays for chance to rebuild after injury agony

Welsh hurdler was World, European and Commonwealth champion, but then the injuries crept in
Israel-Gaza conflict: Secret report helps Israelis to hide facts

Patrick Cockburn: Secret report helps Israel to hide facts

The slickness of Israel's spokesmen is rooted in directions set down by pollster Frank Luntz
The man who dared to go on holiday

The man who dared to go on holiday

New York's mayor has taken a vacation - in a nation that has still to enforce paid leave, it caused quite a stir, reports Rupert Cornwell
Best comedians: How the professionals go about their funny business, from Sarah Millican to Marcus Brigstocke

Best comedians: How the professionals go about their funny business

For all those wanting to know how stand-ups keep standing, here are some of the best moments
The Guest List 2014: Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks

The Guest List 2014

Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks
Jokes on Hollywood: 'With comedy film audiences shrinking, it’s time to move on'

Jokes on Hollywood

With comedy film audiences shrinking, it’s time to move on